Prudent valuation assumes the process of deriving fair value is sufficiently uncertain to warrant additional adjustments that reflect a number of risks. Essentially, it introduces a prudent valuation ‘buffer’ that reduces the value of assets or increases the value of liabilities to reflect risks relating to their valuation. The difference between the ‘prudent valuation’ of an asset (or liability), which is used to calculate a bank’s Tier 1 capital, and the fair value of that asset (or liability) accounted for on a bank’s balance sheet is known as the Additional Valuation Adjustment (AVA).
The AVA is itself split into a number of components, which are:
1. Market Price Uncertainty (MPU) – Article 9
2. Close Out Costs (CoCo) – Article 10
3. Model Risk (MoRi) – Article 11
4. Unearned Credit Spread (UCS) – Article 12
5. Investing and Funding Cost (IFC) AVAs – Article 13
6. Concentrated Positions (CoPo) – Article 14
7. Future Admin Costs (FAC) – Article 15
8. Early Termination (EaT) – Article 16
9. Operational Risk – Article 17
It is important to note that the approach taken to derive a ‘prudent valuation’ follows more of a risk management approach when compared to typical accounting or finance workflows. That is because the methodology is probabilistic – the goal is to find a value that can be achieved with 90% certainty, which means understanding the distribution profile with respect to each risk, while also looking to weigh risks taking into account diversification. This risk-based approach is more data intensive than a typical accounting workflow.